Why you want stocks to go down

A primer on why you shouldn't freak out whenever markets drop, and why you do.

Feb 03, 2022

💥It still amazes me that investors are more focused on day-to-day stock prices than actual business progress.💥

No, I am not talking about amateur investors or the retail crowd. I am talking about professionals running big money.

If this subject interests you, read on…

When prices are up, success is unquestionable. When prices are down, failure is accepted as being self-evident.

In fact, trillions of dollars in capital behave as if they are trading $10,000 and need a 20% pop to buy a new laptop. 👩🏿‍💻

One day they’re on CNBC explaining to the world in detail why they are investing heavily in stocks, and two months later they take a “cautious” stance lest the market sells off more.

Investors know that the market goes up as well as down. They know that even great companies can drop 50% in a year without an impairment to long-term business values. But they still lose their head when they see it happen.

People get smarter but they don’t get wiser. They don’t get more emotionally stable. All the conditions for extreme overvaluation or undervaluation absolutely exist, the way they did 50 years ago. You can teach all you want to the people, you can tell them to read Ben Graham’s book, you can send them to graduate school but when they’re scared, they’re scared.
-Warren Buffet

But therein lies your opportunity

I see market moves as a swinging pendulum. They rally until no one is willing to buy them and crash until no one is willing to sell them anymore.

But even if you are 90% invested and there is a 90% drop, buying with your remaining cash will lower your average by 50%. That’s on a price you believed was good (ceteris paribus) 100% higher from current levels! You see, you want stocks to go down, way down.

But why then so much confusion? Why don’t investors view price declines as the opportunity to strike a very lucrative business deal?

Because people don’t have a long-term commitment to the stock market and investing. They want a quick profit. They want instant gratification. This is why timing is so important to them, because they are not willing to commit time.

They are afraid of drops because they need constant reassurance and confirmation. They need the market to hold their hand while they hold their stocks. When the market lets go, they lose their compass. But if you want to be a good investor, self-reliance is an absolute requirement.

“If you can keep your head when all about you are losing theirs and blaming it on you; If you can trust yourself when all men doubt you, but make allowance for their doubting too; If you can wait and not be tired by waiting...”
Quote from If, by Rudyard Kipling

How can you get a bit of this self-reliance?

The market as a complex adaptive system

First, you have to get rid of the idea that price moves are always indicative of underlying fundamentals or that somehow they are predictive of the future. Prices move and they will continue to move, sometimes violently or even for no apparent reason. Embrace that.

Prices fluctuate much more than business values even though market efficiency would postulate that this is impossible. There is an obvious explanation as to why this happens.

John Keynes wrote about a fictional newspaper contest — where participants where asked to pick the prettiest faces from 6 photographs and write back to the newspaper with their picks. Those who picked the most popular faces would win a prize. Keynes then went on to explain the different levels (or degrees) that one can play this game, and how that relates to the stock market.

"It is not a case of choosing those that, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees."

Breaking down the above quote we note the following:

The first level is to pick the faces that you deem the prettiest.
The second level is to pick the faces that you believe the average of participants believe are the prettiest.
The third level is to pick the faces that you believe the average of participants expects the average opinion to be.

The quick-witted of you would have quickly discerned how this relates to the stock market. But let’s list down the ways.

First level investors pick the stocks that give the best value for the price they are selling at (i.e. the cheapest).
Second level investors pick the stocks that they believe other investors will pick.
Third level investors pick the stocks that they believe other investors expect others will pick.

So far, so good.

Now that we have explained why the stock market doesn’t move in a way which correctly or efficiently prices in the business progress of your stocks or the path of the economy, disengage from using the market as a compass. The market is not efficient.

Better to view financial markets as a complex adaptive system in which a perfect understanding of the individual parts does not automatically convey a perfect understanding of the whole system.

But the key problem remains, just because you know this doesn’t mean you can hold your stocks through painful crashes. Human psychology plays a big role.

Take a breather…we’re almost done.

Market Selloffs

Let’s dissect stock market routs. They are times of intense selling pressure, high confusion and (usually) more fear than reason would merit.

In many cases margin, debt and fear of (further) loss intensifies the selling pressure causing even more losses.

When looking at market prices in a sell-off, it seems that fundamentals don’t matter. Well, they don’t. Because the vast majority of investors don’t invest with fundamentals anyway, and so they sell due to non-fundamental reasons. That’s ~50% of the market. In this category we have forced sellers, passive flows, portfolio rebalancing, traders, algos etc.

The remaining ~50% that do invest with fundamentals, don’t have the conviction and the fortitude to hold their positions in times of market stress. And so they also contribute to the selling pressure. But why is it so hard to stick to the plan?

Human cognition and financial markets

When an event grips markets, it’s easy to fall into the trap of cognitive biases that push you to dump your holdings at the worst time. It could be due to a number of excuses and rationalisations, but the effect is the same.

When the reptilian human brain looks at a sea of red, when he feels the pressure from his investors, his wife and his social circle — when he looks at the news and FinTwit which confirm the negativity, it’s hard to stay sane. The irony here is that the human thinks the news and his Twitter feed are independent of market action, but in fact they are a reflection of it.

The phrase “reptilian brain” derives from the fact that a reptile's brain is dominated by the brainstem and cerebellum, which control instinctual thinking and behaviour for survival.

Prospect Theory

The Nobel award-winning Prospect Theory postulates that individuals assess their loss and gain perspectives asymmetrically. That is to say, the pain from a $10,000 loss is twice in magnitude the pleasure of a $10,000 gain.

The theory concerns how humans perform in decision making under uncertainty.

We see from this graph (red is more than green) that humans are very bad at taking losses. And it makes no difference if said losses (even if big) are temporary and driven by short-term immaterial events like Fed meetings etc. Human cognition cannot naturally distinguish between temporary and permanent loss of capital.

So why do we want stocks to go down? ⤵

Path dependence…and making the big bucks💰💰💰

Simply speaking, this means that the path something has taken up to that point, affects its end result — history matters. In other words:

“When the outcome of a process depends on its past history, on a sequence of decisions made by agents and resulting outcomes, and not only on contemporary conditions.”

To illustrate, a stock sells for $150 with an EPS (after-tax) of $10, which is 15x earnings. You are a long-term investor and own 1,000 (out of 1 million outstanding) of those shares bought at $150 each.

The stock drops to 10x earnings while the company continues to achieve $10 EPS per year. Management considers the drop as an opportunity to buy back shares. For 3 years, the price fluctuates between 8 and 10 earnings allowing the company to retire 200,000 shares (or 20% of the total) at $90 per shares, for $18 million.

Total shares outstanding are now 20% less and the company makes 30% more in earnings because the business has been thriving. Regardless of the fact that the market wasn’t paying attention, the company was still creating value during these 3 years.

The $10 earnings per share went to $13, but shares went from 1,000,000 to 800,000. So the new EPS is $13 * 1.25 (the result of 1000/800) = $16.25. The markets wake up and bid the shares up to 15x earnings again, for a share price of $244.

Cash generating companies can’t always reinvest all their cash for more growth. In that case the prudent thing to do is either distribute dividends or engage in share repurchases.

You have to understand - the lower the price (relative to business value) that the repurchases are done, the more the value added to your existing holdings.

The lagging share price allowed the company to repurchase a $244 stock for $90, not bad.

If the company pays a dividend and you use some of that to add to your position, again, the lower the better. Over a long enough holding period, using your dividends to add to your holdings can make a tremendous difference.

The same principle holds for M&A activity. When stocks are down, valuations are much more reasonable for inorganic growth. Your company could engage in acquisitions that are accretive to the bottom line and add value to your holdings. Think Berkshire Hathaway.

And finally, buying at lower prices simply increases your holding period return. The better the business, the more the potential upside. You can literally make 1000 times your money if you buy a good enough company cheap enough, and hold it long enough.

1000 times my money? HOW?

Avoid the siren song

You only have to get rich once. But investors are prisoners to the market’s siren song. The market sings to them and they decide to sell too early or leverage up excessively to buy more. They let the markets do their investing for them when they would be better served covering their ears.

Like a young Odysseus crossing the land of the sirens to get to Ithaca, you must avoid their song. Focus on the journey, focus on the business, focus on long-term holding, focus on racking up long term advantages. Focus on a company’s destiny, and hence, your own.

Philoinvestor

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